Palantir Stock: A Long-Term Bet With Short-Term Headwinds

I have known and been following Palantir Technologies (NYSE:PLTR) since 2016. I was first introduced to their employees as they implemented foundry at my employer – Foundry provided us an avenue for better data visualization, assisted us with data flow, and day to day operations to and from our deepwater oil and gas facilities. During the implementation of Foundry, and working extensively with a group of extremely intelligent data scientists and forward deployment engineers, I promised the engineer leading the project that if Palantir ever went public I would be first in line to grab shares. I explicitly told him “I don’t want to just be a stakeholder in Palantir’s success but I want to be a shareholder in its success.”

At the time of the direct listing in September 2020, I was moving back to the country from working as an expat overseas. Four years strong of using Foundry first-hand, I had seen the movement they had begun on the commercial side. Use cases and expansion into different industries exploded – I was excited to become a shareholder. On Wednesday, September 30th, 2020, I had just landed at JFK airport and was on the train to Jamaica station as my $10 limit buy order went through. And there it was, I kept my promise, I was a shareholder and stakeholder in Palantir’s (hopefully future) success. I will say, at that time, buying that much stock in any company was a large position for me. But over the next three years, I quadrupled it anyway and the position is where it is today.

Since day one of its direct listing, the company’s growth has slowed dramatically. Back in 2020, year over year growth was humming close to 50% per year, and by the time we got to mid-2023 annual growth had dropped to the low-teens. Since that time, the company’s revenue has doubled, the company has achieved GAAP profitability and released two new products – Apollo and AIP. I have a lot of confidence that the organization has a multitude of products they will bring to market in due time. And those products will eventually reignite top-line growth.

Investment thesis

I have learned how valuable Palantir’s platforms are for companies over the past three years – the ability to organize data in a company specific language or ontology is key for global companies that are floundering in inefficiency and data mismanagement. Palantir’s Foundry is like Microsoft’s (MSFT) 1985 moment when they released the Windows operating system. It took time, but once people caught on there was no stopping that freight train and Office 365 is where it is today.

The use cases for Foundry and Gotham operating systems are continuing to grow with implementation in defense, healthcare, energy and a laundry list of other industries. Use cases that have been shared with the Palantir community through FoundryCons and AIPcons show clarity of its extreme value, and while the software is “expensive” the benefits in efficiency in simplifying old processes, eliminating legacy systems and data organization outweigh the costs by a significant margin.

Palantir has created these products with focus on data rather than ease of use – that may turn off some, but this focus enables its true power. It’s like picking up an iPhone in 2008, you have to learn the OS and unleash its power in time.

All that said, the consistent growth in customers over the past several years has not equated to similar growth in revenue, even with large awards from the Army, Department of Defense and the incoming UK NHS deal, it is not sufficient enough to move the revenue needle more than a few percentage points per year. Therefore more deals and customers need to step up to the plate to kick-start revenue growth and bring it back to 25%+ year over year. My hope and prayer for this growth is Palantir’s AIP, or artificial intelligence platform.

Palantir’s AIP is the enterprise equivalent to a chat prompt AI bot that integrates intimately with interactive large language models with the company’s data stored on the Foundry or Gotham platforms. The key here is interactive, as you will train the models with interaction and your decisions rather than relying on the AI to provide the answers for you.

So as of now, post 4Q earnings – I see products that can provide the promise of a bright future and a kickstart for growth, but until I see consistent growth numbers of 20%+ YoY catch up, it is hard for me to justify buying more of the stock. I am putting my initial Seeking Alpha rating of Palantir as a hold with a $25 price target until year end. This is slightly above the $24 market close as of February 16th. The Street holds a price target range from $5 to $30 with the average being $18.63, or a 25% discount to the $25 price target.

I want to note, I am extremely bullish on the company and hold shares for the foreseeable future – so expect more updates from me on a quarterly or semi-annual basis. I envision a longer term market cap between $150b-200b in the next 15 years, but for now, I see the company’s price hovering between $20 and $30 throughout 2024 as it fights to justify a $60bn market cap. If individuals do have the patience for volatility and time horizon, this could be a great 10 year hold.

4Q 2023 Earnings

Originally, I was going to release my pre-earnings estimates for Palantir, and my estimates were rather close with the exception of adjusted cash flow from operations. The 50% adj cash flow margin in the 4th quarter was explosive and unpredictable based on previous earnings reports released by the company.

For those that have followed, Palantir outpaced on revenue expectations in the 4th quarter leading to a FY 2023 revenue base of $2.23 billion and ended the year with $3.7 billion in cash.

Adjusted free cash flow came in above $730m, or a 33% margin and GAAP net income ended over $200m for the year, a 9% margin.

Considering Palantir has gross margins north of 80% and they are prudent about keeping operating expenditures low, I knew that operating margins and net margins would start to climb in time. That said, adjusted free cash flow margins ending the year north of 33% is about 8% higher than what I expected for 2023 and was more like numbers I was expecting to see in 2024.

And the GAAP net income margin of 9% observed in FY2023 is 2-3% higher than the expectations I had for 2023 – especially given Palantir’s compensation package is heavily dependent on share-based compensation and SBC is a drag on GAAP net income.

With the company market cap over $50bn and FY23 GAAP net income of $210m, this puts a trailing twelve month (TTM) P/E ratio of Palantir at north of 200x. Using a more reasonable metric like adjusted free cash flow, which removes the burden of share based compensation, one can measure Palantir’s P/aFCF at 75x.

Expensive. Looking at 2024 valuations ease the expense a bit with aFCF coming in between $800m-$1b, dropping the forward P/aFCF to 55-69x… Still expensive.

But the bright side of these lofty valuations show the optimism that retail investors have in the company and its products. Coupled with the impressive net income and free cash flow margin expansion as GAAP net profitability is just 5 quarters old…. The margin expansion at this pace should give hope that years down the line the valuations should return to more typical levels if top line growth persists.

That’s my sticking point, though, you have to grow into the current valuations of the stock. We need color around what long term free cash flow and net income margins should be. There is a large window between the 80%+ gross margins and the 9% net income that was just provided in FY 2023. Where should we draw our models? All of this just seems too early to tell. We have to let time play out a few more quarters and let revenue grow and see how margins trend ourselves – hence the HOLD rating.

Another lofty example of valuation for Palantir is price to sales for 2024. With $2.6b or so in revenue expected for 2024, that places the P/S north of 20x. Once again, expensive, and only makes sense if revenue growth was expanding at greater than 20% per year and had an excellent FCF or net income margin. If a P/S of this magnitude persists, it only means continued overvaluation on a P/E or P/FCF perspective.

I am not dinging the company too hard on these metrics yet as the company has only just established GAAP net income 5 quarters ago, but in time these metrics will matter and will be a drag on the stock if they do not improve, and this honestly may be why the Street is so bearish on the stock at the moment compared to Seeking Alpha peer analysts.

Where Does The Street Stand on Palantir?

Street and Seeking Alpha analysts for Palantir differ on recommendation for the stock, with the Street maintaining a hold rating over the last 12 months, Seeking Alpha analysts have teetered back and forth between buy and hold. My $25 price target for year end 2024 is on the higher end of the Street price range, with an average price target of $18.63 over the next 12 months. This represents a 25% discount to today’s prices.

Peer analysts on Seeking Alpha currently rate Palantir a 3.8 out of 5, which signals a buy on the stock. 6 SA analysts rate the stock a strong buy, 9 rate the stock a buy, and 5 rating it a hold. There are three sellers.

Wall Street analysts currently rate Palantir a 2.94 out of 5, with 3 analysts rating the stock a strong buy, 1 consider it a buy, 8 consider it a hold. There are 2 sellers and 3 strong sellers on the stock.

Quant currently rates Palantir a 3.47 out of 5, a strong hold, soft buy. Quant grades Palantir’s growth, profitability, momentum and revisions at least an A- rating, while valuation is too strong and is rated an F.

Major Risks, Uncertainties and Drags on the Stock

Share-based compensation / Dilution

What I say here won’t be unique to other SA analysts, and the dilution and SBC is not as much as a problem as it was when the share price was at $6 just a short year ago, however, the $400m-$450m/year in share based compensation will impact GAAP net income in the short term elevating the P/E ratio. At the current rate, dilution would be less than 1% per year based on recent comps in 2023. Will that sustain? As the organization grows headcount will that end up being a 2% dilution? More? And while Palantir has approved up to $1bn in buybacks, it has yet to deploy them and at what rate is it appropriate to begin buybacks? Do you start now and partly offset the share based compensation? Do you wait until you make sufficient cash flow from operations and GAAP net income to fully offset? How will buybacks compete with other needs in the financial frame? All prudent questions to ask and it is way too early to tell. We must watch and see.

Lack of Capital Investment

Now many of you that have talked to me know I am not the biggest fan of share buybacks. I much prefer reinvestment of capital back into the business and R&D to be the number one priority. Dividends and/or buybacks are secondary or even tertiary depending on the balance sheet. We do not have to worry about Palantir’s balance sheet at the moment.

That said, when Palantir continues to release new products at an extremely low cost of capital and the group rarely deploys any capital (other than the SPAC investments in 2021), buybacks may be your only plausible way to easily deploy capital.

But moving back to the SPAC investments, I do not think this was necessarily a horrible opportunity to start deploying capital. I will say, the moonshot investments chosen may not have been executed to perfection, but there are several SPACs which remain in business and continue to use Foundry or Gotham as their central operating systems to this day. I hope Palantir considers choosing wiser, less risky choices in the future and couple those choices with products like FedStart and OSDK (Ontology Software Development Kit). In fact, I hope start-ups come to Palantir to use FedStart and OSDK and then a Palantir VC arm can establish a symbiotic relationship with start-ups and Palantir could figure out the appropriate way to deploy a portion of their capital on hand.

Conclusion

Based on my use and the examples provided by other organizations in FoundryCons and AIPcons, I am bullish on the long-term potential for Palantir and the deployment of their future products going into the latter half of the decade. However, I am initiating a HOLD rating with a $25 price target for year end 2024.

The negative reasons and uncertainties for this hold are numerous. Firstly, a steady trend of slowing revenue growth over the last several years with a minor uptick in top line growth except in recent quarters. Second, current valuations based on P/E and P/S ratios are lofty, making the current price expensive, thus requiring the stock to expand the top-line in the shorter to medium term to justify these valuations. There’s also the uncertainties associated with continued share based compensation that drags on GAAP net income in the shorter term, exacerbating the lofty P/E ratio. Coupling the SBC uncertainty with the uncertainty on lack of plan for future capital deployment, and previous deployments of capital were not ideal. Is there a way to justify a dedicated VC arm?

The negatives are partly offset by numerous positives. Firstly, the strong margin expansion over the last several quarters, especially since reaching GAAP net income positive 5 quarters ago has been more than impressive. Second, products like Apollo, AIP, FedStart and OSDK have contributed to recent top-line growth YoY, could it be the pivot point that Palantir needs going forward? And finally, could an advancement like Palantir’s operating systems and products just take time to go to market and need to saturate before a real S-curve begins. Foundry and Gotham have received great praise from companies across a multitude of sectors and industries that are all focusing on building custom applications with ontology to organize data in a clean and concise manner. Maybe we just need more time.

As I alluded to, the negatives seem to be shorter-term problems that are outweighed by positives which focus more on the long-term potential. Thus, for the patient investor with tolerance for volatility and a decent time horizon, you could continue to add shares here. Those with sizable positions and lower risk tolerances would be wise to wait for a pullback in the coming months as I anticipate shares to trade between the $20 and $30 range throughout 2024.